The Summer of Our Discontent

Like racing fans, options traders seem to be spending most of their time watching from the infield as stocks lap around their six-month trading range, rather than getting behind the wheel themselves.

The two main reasons for this hesitation to push the pedal to the trading metal are the current low-volatility environment, which limits opportunities, and uneasiness about further declines attributed to a host of factors, such as terrorism and interest rate hikes.

I spoke this week with a handful of people who represent a cross-section of the industry to see what strategies they were using. While there was a nearly uniform long-term bullishness and a general consensus that the market is approaching its lows for the year, none of the people I spoke to seem ready to call a bottom, and they all offered different approaches to position one's self for an improved market.

Not Like It Used to Be

Even independent, active traders, who should be the beneficiaries of the leveling of the playing field provided by online brokers, electronic exchanges and sophisticated analytical tools, are finding short-term trading more difficult.

Bill Wingate, an independent trader and former member of the Chicago Board of Options Exchange, who now trades from his home office, said, "Between efficient pricing and a lack of no volatility, you've basically removed the edge from being a full-time or active daytrader."

This is forcing Wingate to use more directional-based strategies and hold positions longer. He explains that "the pool of stocks that you can count on to move a buck a day is probably less then 100, and the ones that have enough liquidity in both the stock and options to trade sufficient size is really just maybe a dozen. That's not enough for everyone to make a living, locking in short-term price on a daily basis."

Consider the challenge of carving out a profit if a stock moves by a $1: the at-the-money options' price is expected to move 50 cents, the bid/ask spread for a liquid options market will be a dime (thinner markets can see spreads of 25 cents or more), meaning you might have to give up 20 cents of the option's "fair value" in executing the two or more transactions required to close out or lock in a profitable trade. This leaves you with just a 30-cent margin for profitability if you catch the exact top and bottom of a daily trading range.

This can be quite attractive if it can be done in sufficient volume, but as Wingate says, there are very few names that have the consistent liquidity to move easily in and out of combination (stock and option) trades. For his part, Wingate has been focusing on earnings releases and hopes that business and volatility improves in the fall. Indeed, the fact that the CBOE has listed and begun trading November index options three weeks ahead of schedule highlights the belief and hope of traders that the election and the October earnings seasons will bring expanded trading opportunities.

Looking for Clarity, Finding Solidarity

When I hear traders and pundits say they are looking for "more clarity and confirmation" before committing capital, I picture a bunch of kids standing on a dock at a lake; everyone is pretty excited to jump in and swim, but nobody wants to go in first.

Elliot Spar, an options strategist with Ryan Beck, thinks like many others that if the market can hold the May lows and form something of a double bottom here, it will bring money back into the market and the ensuing momentum will become somewhat self-fulfilling.

So, rather then diving in head-first, let's look at some options strategies that will allow you to put a toe in and get acclimated while we wait for others to jump in.

Mike Greenberg, vice president of Institutional Sales at Midwood Securities, told me that many of his clients, which include professional arbitrage traders and highly capitalized individuals, "are reluctant to make bets and have moved a lot of cash over to the sidelines." He says that most of his clients prefer to use strategies that sell premium, such as covered calls or some form of calendar spreads, and that "these have simply stopped working as the market has come down in terms of price and I.V. and there is a general malaise" among traders.

But Greenberg has recently started to suggest the selective selling of put options on beaten-down names as a way to generate income and build positions at discounted prices. In the near term, he thinks that with Krispy Kreme ( KKD) trading around $18.50, selling the August $17.50 put for 70 cents provides an attractive risk/reward for the three weeks until expiration.

Along those lines, I'll suggest that I think Nvidia's ( NVDA) August $12.50 puts at 45 cents look like an attractive sale. The stock has tumbled 33% to $14 in the last four weeks and a sale of these puts, which are still out of the money by 10%, provide a chance to earn 3.5% over the next three weeks or let you purchase the stock at $12.

Spar told me he has switched gears, saying "three to six months ago I was suggesting clients do overwrites on stocks they owned that were hitting new highs, now I'm recommending married put situations." (A married put consists of buying stock and related put options; it provides downside protection against a steep decline while maintaining unlimited upside profit potential.)

Recently, Spar established such a position in Fossil ( FOSL) by purchasing the stock near $24 and buying its March 2005 put for around $2.25 per contract. He likes this position because "even though the shares have recently declined, its uptrend remains intact and the puts give me cheap protection through another three earning periods."

That strategy of using long-dated puts in a married position is important because it leaves you less exposed to time decay during the earlier part of the holding and also provides time for a stock price to rise sufficiently above the break-even point and overcome the cost of the put option.

Jon "Dr. J" Najarian, chief market strategist at PTI Securities, is prescribing keeping things simple with straight-forward vertical call spreads. "I'm looking for some beaten-down stocks that don't have to move much to give me a 100% return on a limited-risk investment," he said.

He recently established a call spread in Cisco Systems ( CSCO) by buying the January $20 call and selling the January $22.50 call for a net cost of $1.10 per spread. If Cisco moves back above $22.50, the spread will be worth $2.25, giving him a 125% gain on his limited risk investment.

The overriding view of the market seems to be that it should be higher by the end of the year, but these relatively low-risk options strategies are saying, "I'll believe it when I see it."

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.